finance essay

Key Concepts In Corporate Governance Finance Essay

Published: 23, March 2015

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Most of the key concepts of corporate governance provide the framework of reference for the strategic management of the firm. Corporate governance, however, must not be confused with management, ethical behavior nor the social responsibility of the firm. Practicing good corporate governance helps improve the execution of corporate strategies, under the supervision of the Board of Directors of a firm.

Shareholders [1] own the firm. It legally belongs to them by virtue of their investment. As a result stockholders have the right to elect the directors, who then hire the managing executives. The Board of Directors represents the interests of the general shareholders in the firm.

The directors, as representatives of the shareholders, determine the contentious issue of management compensation, rewarding them if performance is superior or replacing them if performance is poor.

Figure 2: Roles of the Chairman and the CEO

Directors monitor and control the actions of the executive management. The directors have little choice but to operate like this, because shareholders will remove them if they fail in their fiduciary duty. The chart in Fig. 2 shows the different roles and responsibilities for the Chairman of the Board and the CEO. The current corporate governance best practices highly recommend the separation of the duties between the board and management. This separation comes from the basic responsibilities where the CEO is responsible for the day to day operations of the firm, while the Board is responsible for strategy and oversight. These two must be separate to ensure the success of the firm, and protection of the rights of the shareholders and stakeholders.

The objective of management of a firm is to implement the strategy approved by the board of directors by taking actions to maximize the value of a firm's stock. In this respect, executive management's basic overriding goal is to create value for shareholders or investors. This goal is consistent with the wealth maximization objective sought by shareholders when investing in a firm.

Figure 3: Complimentarity of Duties

In the past, most shareholders were passive. They simply voted with their feet: that is, sold their stock if they thought a particular firm's management was not performing well. Today, ownership is increasingly concentrated in the hands of institutional investors such as pension funds and mutual funds. Their holdings are so large that simply selling all their s

hares would depress the stock prices, thereby causing loss of value. This has increased shareholder activism, where shareholder group together to affect changes in the way a company is run, by proxy voting.

Institutional investors increasingly use "proxy fights" and takeovers to force changes in poorly performing companies. Institutional investors have now become active shareholders in the corporate governance of the firms in which they have invested large sums of investor capital owned by their clients.

The duties of the CEO and the Chairman of the Board must be complementing each other. Fig. 3 summarizes these relationships. There must be a good working relationship between the board and the CEO and senior management. After the board appoints the senior management, it is delegated the responsibility to run the business on a day to day basis to implement the strategy. This delegation will require a productive albeit complex, and harmonious relationship between the chairman and the CEO of a firm. The board's role in this relationship is first to understand and approve of the CEO's strategies and plans and then to monitor the execution of those plans and to periodically evaluate the performance of the management.

The board must maintain the role of providing guidance and oversight to the CEO and decide whether, when, and how it should intervene. The way in which the board executes its role is crucial to the success of the relationship and ultimately of the business. The Board must be careful not to be overly involved in the day to day running of the business. Any interference by the Board into the management style may undermine the effectiveness of the CEO. It will also find it difficult to hold the CEO accountable in the case of poor results as through its interference Board may have created that consequence. If a board is too detached from providing adequate oversight for the management, or be too passive in intervening, it is not carrying out its responsibilities. Board members must strive to find the right balance between these two extremes, staying proactive and vigilant in carrying their responsibilities as directors without interfering. In finding this balance and harmony, it is of primary importance that the members of the board remain independent of the CEO/management. The chairman of the board must seek and foster the full cooperation and complementariness between the board and the CEO.

SECTION III: CORPORATE GOVERNANCE and VALUE CREATION

During most part of the 1990s, privatization process resulted in the transfer of the rights to own equity shares in the state owned enterprises to all the citizens in the former socialist countries. This ownership change did not initially involve the actual cash investment of capital to purchase the shares by the public. Rather it involved the distribution of vouchers or certificates of future equities offered to citizens which were then either converted into shares in the privatization process, or were by and large sold to others for minimal amounts prior to the actual privatization process.

The lack of an actual investment outlay did not motivate shareholders adequately to act as active investors demanding a return on investment. They did not have the incentives like their counterparts in a market economy where viable securities intermediation process exists. Thus the new shareholders required a more effective understanding of the rights and responsibilities of share ownership in a corporation by the new shareholders.

This evolution towards the formation of a market economy may have been a necessary step. However, its initial impact essentially lent itself to create a market for corporate control by insiders, such as management. The lack of effective understanding of share ownership resulted in abuses of shareholders and stakeholders rights in some cases, and the impact of wealth maximization as the main goal of a firm suffered, leading to the loss of investor confidence.

The vision of corporate governance in many post privatization countries has thus far been to create a market for control of the enterprises through self-dealing and asset stripping, rather than value creation on behalf of the shareholders. Self-dealing and similar infractions, is far removed from value creation and thus violates the rights of all of the shareholders.

This causes major impediments to the further development and access to finance for the enterprises, with implications on the overall economic growth, competitiveness of business enterprises, and investor confidence in the financial markets.

The lessons of the recent financial crises that began from the US and that had global implications, has forced all policy makers on a global scale that the public policy aspect of corporate governance is a major concern and it requires better understanding at all levels of the government not just the private sector.

It has also emerged that sound corporate governance is an essential pillar of a holistic anti-corruption strategy - one that promotes integrity in both the public and private sectors. Effective corporate governance extends beyond the critically important task of preventing and deterring the bribery of public officials.

In order to successfully prevent the occurrence of corrupt practices in the public and private sector, cooperation between both sectors will promote transparency, accountability, responsibility and integrity in their interactions. This is where all of the stakeholders of a firm have the responsibility to interact closely in the promotion of the viability of their firms in which they have self-interest, towards the goal of wealth maximization.

The wealth maximization concept implicitly assumes that scarce resources are allocated efficiently and productively resulting in the profitable operation of the firm. In the transition countries, due to many disparate factors not considered at the time the privatization methodologies were designed, linkages between the elements of the system break down.

In this regard, implementation of "good corporate governance practices" begins from a set of circumstances that seems to make the concept of "shareholder wealth maximization" less practical. This note intends to show that the ultimate goal of a firm; "the maximization of the wealth of shareholders" (or shareholder value creation) is an attainable goal, and that all stakeholders of a firm will benefit from this process.

In this regard, efforts to maximize stock prices will benefit societies in a number of ways:

These efforts help to make business operations more efficient, and thus increase the competitiveness of the economy.

In order to maximize stock prices, managers must offer goods and services that consumers desire - otherwise known as being more 'competitive' - and they must price those goods and services as low as possible, and low prices require efficient, low cost operations.

The quest for stock price maximization also leads to innovation, new products and services, and improved productivity.

The wealth maximization motive allows for capital accumulation that will be allocated into new and profitable investment opportunities through financial markets, helping create new jobs and other opportunities.

Consumers benefit as a result of management's efforts and so do the employees, because efficient, profitable firms are able to offer more stable higher paying jobs, advancement opportunities, and generally better working conditions.

Stockholding public also benefits, as increasingly through pension retirement plans or direct individual investments in companies, many adult working people are participants as investors in the economic activities. These people are interested in the successful operations of the firms, hence higher stock prices will help most citizens.

Also, through the "wealth effect" higher stock prices lead to increased spending and to lower "cost of capital" to firms. Both of these effects stimulate the economy, producing more and better jobs, and most importantly, economic growth.

Shareholders and Stakeholders of the Firm:

There are two types of stakeholders of a firm: (1) Primary Stakeholders which include: The Board, the Shareholders and the Executive Management; and, (2) Other Stakeholders: The Management, Employees, Customers, Suppliers, Community, the Government, Financial Markets, and environments agencies and NGOs. Fig. 4 depicts the relationships.

The modern way of approaching the firm's relationship with the stakeholders has gained more significance. The Stakeholders relationship is now considered to the best benefit of a firm, and is a matter of "enlightened self interest"

According to the OECD Principles of Corporate Governance (2004), the CG framework ought to recognize the rights of the stakeholders as established by law, but also by social norms. OECD principles of corporate governance recommends a role for the stakeholders which emphasizes: "The corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises."

Figure 4: The Stakeholders of the Company

OECD principles of corporate governance supports the rights of stakeholders that are established by law or through mutual agreements must be respected. Secondly, stakeholders should have the opportunity to obtain effective redress for violation of their rights. Thirdly, performance-enhancing mechanisms for employee participation should be permitted to develop. Fourth, where stakeholders participate in the corporate governance process, they should have access to relevant, sufficient and reliable information on a timely and regular basis. Fifth, stakeholders, including individual employees and their representative bodies, should be able to freely communicate their concerns about illegal or unethical practices to the board and their rights should not be compromised for doing this. Finally, sixth, the corporate governance framework should be complemented by an effective, efficient insolvency framework and by effective enforcement of creditor rights.

SECTION IV: AGENCY RELATIONSHIPS: PRINCIPAL - AGENT PROBLEM

In an ideal world, all shareholders would agree that managers should follow a simple investment criterion: Take projects until marginal rate of return equals the marginal cost of capital (which is the market determined discount rate). Shareholders' wealth is calculated as the present value of all future cash flows from an investment throughout its economic life, discounted at the "opportunity cost of capital." The "opportunity cost" is essentially the market determined "required rate of return" or the "risk adjusted discount rate" that is used in the discounting process [2] . The decision criterion is to choose the investment opportunity that provides the largest net present value from the competing alternatives.

The decision to select the investment opportunity that maximizes the wealth of the shareholders results in efficient allocation of scarce resources. This rational selection process relates very closely to the effective corporate governance practice. But from time to time, this rationale may be compromised in favor of political considerations.

Shareholders would have to agree to the investment criterion they should give to managers through their elected Board. The investors must also be able to monitor management decisions relentlessly and very closely.

Figure 5: The Principal-Agent Dilemma

This management monitoring process must occur at a very low, or no cost, if they are to make sure that management really takes every decision in a way that maximizes their wealth. In other words, investors holding the shares of an enterprise must see to it that managers' interests are closely aligned with their own. Monitoring is thus an important aspect of any investment decision.

Ownership and control are separated when a professional management team is hired with the responsibility to manage the corporation on behalf of the shareholders, given the business targets determined by the Board [3] . The Principal - Agent dilemma is about the conflict of interest between management and shareholders and corporate governance provides the mechanism to resolve this conflict.

Aligning the interests of managers with the shareholders

There is no reason to believe that the management, as the agent for shareholders, will always act in the best interest of the shareholders, who are the principals. In most agency relationships, the owners will incur non-trivial monitoring costs in order to keep the agent in line. Consequently, the owners face a trade-off between monitoring costs and forms of compensation that will cause the agent to always act in owners' interest, and not self-interest.

At one extreme, if the agent's compensation were all in the form of shares in the firm, then monitoring costs would be zero. This type of arrangement is practically impossible unless the manager also happens to be the owner. In most cases this is not the case.

Since ownership rights of investors are protected under appropriate legal and regulatory frameworks and presumably enforced effectively or not by regulatory authorities, an agent's behavior is supposed to be monitored by the investment community through various institutional arrangements.

Under properly implemented legal and regulatory frameworks as the background for business, "the agent" can almost always be able to receive some additional compensation for good performance in the form of both pecuniary and non-pecuniary benefits such as larger office space, cars, expense accounts, bonuses, options and other types of executive privileges. Effective corporate governance practice can be induced by effective incentive structures for the managers that will lead them to perform better, achieving the goal of wealth maximization.

At the other extreme, the owners would have to incur inordinate monitoring costs in order to guarantee that the agent always makes the decisions the owners/shareholders would prefer. Somewhere between these two extremes lies an optimal solution to the agent-principal conflict.

Managers are empowered by the owners (shareholders) of the firm to make decisions. However, managers have personal goals that may compete with shareholder wealth maximization, and such potential conflicts of interest are addressed by "Agency Theory".

An Agency Relationship arises whenever one or more individuals, called "principals" (1) hire another individual or organization, called an "agent" to perform some service; and, (2) then delegate the decision making authority to that agent. The resulting primary agency relationships occur between:

shareholders and management

management and creditors

management, shareholders and creditors in times of distress.

The potential agency problem arises whenever the manager of a company owns less than 100 percent of the stock of the firm.

If the firm is a proprietorship managed by its owner, then the owner- manager will presumably operate so as to maximize his own welfare, with welfare measured in the form of increased personal wealth, more leisure, or perquisites.

When the owner- manager incorporates his company and then sells some of the stock he owns to outsiders, a potential for conflict of interest will immediately arise.

Upon the transfer of the ownership of some of the stock of the firm to outside investors, the owner-manager has less of an incentive to work too hard to increase his wealth, as some of that wealth will have to go to the new stockholders.

Also the owner-manager will have a larger incentive to consume more perquisites as some of these costs will be borne by the outside investors.

In essence, the fact that the owner-manager will no longer have the possibility to enjoy all of the benefits of full ownership of the firm through the wealth created by his efforts, nor bear all the costs of perquisites will increase the likelihood that he will have more incentive to take actions at the management of the firm that are not necessarily in the best interests of all the shareholders.

The above case represents the conflict of interest that lies at the heart of the Agency problem and thus, potential weakness in corporate governance. In this case, the shareholders will need to monitor the actions of the managers so as to align the interests of the managers with their own interests in the firm. Much of the reason for the conflict of interest between the principal and agent is due to information asymmetries, because the agent has now gained more control over the business than the principals who are on the outside. The duty of the Board of Directors is thus to minimize the possibility of information asymmetries that cause higher costs due to monitoring, and oversight. (See Figure 6).

Figure 6: Principal-Agent Dilemma Stems From Asymmetric Information.

When the ownership share of managers in the firm is less than 100 percent, their primary goal may become that of maximization of the "size" of their firms, instead of seeking active ways to maximize the "wealth" of their shareholders. This issue is at the heart of the principal-agent dilemma.http://upload.wikimedia.org/wikipedia/commons/thumb/a/ac/Principal_agent.png/320px-Principal_agent.png

The principal-agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem that the two may not have the same interests, while the principal is, presumably, hiring the agent to pursue the interests of the former.

Various mechanisms may be used to try to align the interests of the agent in line with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), or fear of firing.

The principal-agent problem is found in most employer/employee relationships, for example, when stakeholders hire top executives of corporations. Numerous studies in political science have noted the problems inherent in the delegation of legislative authority to bureaucratic agencies.

As another example, the enforcement of legislation (such as laws and executive directives) is open to bureaucratic interpretation, which creates opportunities and incentives for the bureaucrat-as-agent to deviate from the intentions or preferences of the legislators. Weaknesses in the intensity of legislative oversight also serve to increase principal-agent problems in implementing legislative preferences.

Increase their job security to prevent the likelihood of hostile takeovers;

Increase their own power, status and salaries;

Create more opportunities for their lower and mid-level managers (crony capitalism)

Obviously managers can be encouraged to act in the best interests of the shareholders through a set of incentives, constraints, and sanctions and penalties.

These tools can be most effective, if shareholders could effectively observe or monitor the actions of managers by ensuring the alignment of the interests of the managers with that of the shareholders.

In order to ensure that the interests of the managers are aligned with that of the shareholders, some agency costs must be borne by the firm.

These agency costs occur due to the moral hazard problems inherent in such situations, where managers take actions that are more in line with their own self interests. Moral hazard problems exist because agents (managers) take unobservable actions that cannot always be closely monitored by the principals (shareholders). This creates a certain degree of hazards, leading to potentially risky situations for shareholders.

Agency costs include all costs that must be borne by shareholders to encourage managers to maximize firm's stock price, rather than act in their own self interest. Agency costs may include (Figure 7):

Monitoring Cost: Expenditures to monitor managerial actions such as audit costs. This occurs because of the known misalignment of interests between shareholders and management.

Incentive costs: Expenditures to structure the organization in a way that will limit undesirable manager behavior-such as appointing outside independent directors to sit on the board of directors. Incentive costs represent cost of making the managers more attentive to their requirements and goals in the firm.

Divergence Costs: Opportunity costs which are incurred when shareholder imposed restrictions such as requirements for stockholder votes on certain issues limit the ability of managers to take timely actions that would enhance shareholder wealth. Divergence costs are incurred by shareholders when managers do not put in adequate efforts to maximize firm value with their actions and performance.

Figure 7: Agency Costs

The main role of good corporate governance is to reduce total agency costs in order to maximize shareholder value

If shareholders make no effort to affect managerial behavior and hence incur no agency costs, there will inevitably by the loss of some shareholder wealth due to improper manager actions.

The stockholders own a firm, while officers (executive management) effectively control the firm. This situation comes along because many thousands of investors who may own stock in publicly listed firms could not collectively make the daily decisions needed to operate a business. Thus, firms hire managers to do the work on behalf of owners (shareholders).

Most shareholders do not wish to take part in the daily activities of a business. These shareholders act like passive investors, and do not act as active owners. This difference is subtle but important. Owners focus on the business performance of the firm, and investors focus on the risk and return of their stock portfolios. While diversifying reduces risk for an investor, ownership of many companies also makes participation and influence in those companies less likely. Therefore, investors tend to be inactive shareholders of many firms.

This is the source of the problem known as separation of ownership and control-leading to the Agency (or the Principal-Agent) problem mentioned above. In their 1932 book entitled "The Modern Corporation and Private Property," Berle and Means argued that with managers freed from the interference from vigilant owners, they would only pursue enough profit to keep shareholders satisfied while they sought self-serving gratification in the form of perks, power, and/or fame and recognition. Because managers gain control of a company effectively, this causes of the agency problem, and it beards significant costs for shareholders.

The purpose of corporate governance is to try to align the interests of managers with those of the shareholders to help minimize agency costs.

Stockholders versus Managers

There are some specific mechanisms to motivate managers to act in the best interests of the shareholders:

Managerial compensation:

Management compensation ought to be designed with the following objectives:

To align management actions as closely aligned with the interests of shareholders who are primarily interested in price maximization

Management performance must be measured by a number of concrete outcomes. One such measure is the Economic Value Added (EVA) concept.

EVA is superior of the ROE and EPS measures because it measures the true profitability of the firm leading to value creation. EVA is calculated by subtracting annual cost of all the capital a firm uses from after tax operating profits.

Shareholder activism:

Direct intervention by shareholders is becoming a more common phenomenon in the corporate governance processes. Increasingly institutional investors are becoming more and more vocal in the governance of the firms in which they invest on behalf of their participating members.

Institutional capital has more interest in the companies they own stock in, because of the implications of selling large chunks of securities from low performing companies. The markets react negatively when large sums of stock must be traded in the markets in a hurry. Rather than selling the stock and moving on, many institutional prefer to work together with the management of the company to work a solution to performance problems.

The most fundamental change that the shareholder activism is trying to bring about is the more independent board of directors.

All too often, in the past managers (agents) had control of the directors, functioning mostly like a rubber stamp board, that had diminished the accountability of the management. This is why institutional investors are pressing for independent boards.

Many institutional investors prefer to see an outside director installed as chairman of the board - an insider chairman of the board may not be too trustworthy to serve in the best interests of the shareholders.

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